Intermediate Run Recommendations

Recommendation vi.

The BLS should study the behavior of the individual components of the index to
ascertain which components provide most information on the future longer-term movements in
the index and which items have fluctuations which are largely unrelated to the total and
emphasize the former in its data collection activities.

Elsewhere in their report, the commission emphasizes that the objective of the CPI
should be to measure changes in the cost of living. That is, the CPI for 1998 should
measure change in the cost of living during 1998. This recommendation, however, suggests
that data collection activities should focus on a different objective, namely to provide
information on the future longer-term movements of individual prices or the index as a
whole. Forecasting inflation is a widespread and important use of the CPI, of course, but
one that is conceptually distinct from the measurement of cost-of-living changes. If
prediction of future inflation, or the measurement of "inflationary pressure,"
were the measurement objective of the CPI, this might imply different choices with respect
to the formulas and weights used in construction of the index, as well as with respect to
the allocation of the sample. The commission, however, emphasizes the use of the CPI as a
measure of past and contemporaneous changes in the cost of living in choosing the index
formulas and weights, on the one hand, while emphasizing the uses of the CPI in
forecasting future price movements in determining the sample allocation, on the other.
This appears to be an internally inconsistent strategy.

It is important to recognize that the BLS determines and allocates its data collection
resources based on rigorous statistical considerations. Sample resources for the CPI are
allocated between the two major price surveys, Commodities and Services (C&S) and
Housing, according to the relative importance and variability of the survey estimators for
each component, while taking into account the relative costs of each survey. The sample
for the C&S component of the CPI is designed to allocate resources systematically
among major item groups and sample cities, utilizing models to minimize the sampling
variance of estimated price change over a six-month interval, as measured by the all items
(less shelter) national CPI, subject to cost and sample coverage constraints. Solution
allocations among items, outlets, and cities thus strike a balance with respect to the
contributions of components of sampling variability by sample items, their relative
importance with respect to the total consumer budget, and the relative cost of data
collection and processing, while keeping within the cost and coverage constraints of the
program.15

In its discussion of this recommendation, the commission suggests that resources
devoted to the sample for bananas, a perishable fresh fruit whose price-change sampling
variability has been estimated to be substantial, but whose price fluctuations are
"not systematically related to the underlying trend movements of the CPI," would
be better allocated to surgical treatments, consumer electronics, and communication
services.16 The potential for saving
resources by reducing collection of data for items like bananas is fairly limited because
the marginal cost of collection and processing is quite smallthe stores are already
being visited to collect other grocery items and very little analysis is required after
collection. Moreover, because the C&S sample has been allocated to minimize the
variance of six-month price change, a reallocation of resources away from any item with a
high sampling variance toward other items necessarily would diminish the reliability of
short-term movements in the all items index.

In summary, the BLS believes that this proposed redirection of data collection efforts
would be inconsistent with the primary objective of the CPI  to approximate changes
in the cost of living. BLS thus does not plan to implement this recommendation.

Recommendation vii.

The BLS should change the CPI sampling procedures to de-emphasize geography,
starting first with sampling the universe of commodities to be priced and then deciding,
commodity by commodity, what is the most efficient way to collect a representative sample
of prices from which outlets, and only later turn to geographically clustered samples for
the economy of data collection.

Because geographical coverage impinges on many aspects of the CPI data collection and
index estimation process, the practical meaning of this recommendation is somewhat
unclear. As emphasized above, the allocation of the CPI sample has a rigorous statistical
basis. By the same token, the importance of the geographic structure underlying the CPI
makes it a continuing subject of BLS research, with the goal of improving the efficiency
of CPI data collection activities and thereby the accuracy of the index.

Deciding, commodity by commodity, what is the most efficient way to collect a sample
has been and will continue to be the standard BLS practice. In several cases, for example,
postage and used cars, the BLS currently collects data on a national level. In most cases,
however, it is not possible to select samples of specific items at the national level
because of the lack of a national list (or frame) of items to sample, together with the
sales volume information needed to determine the probabilities of selection. Moreover, if
specific items were selected nationally, there would not usually be a feasible way to
determine whether a selected item was, in fact, carried by any particular sample retail
outlet. These considerations have led the Bureau to do sampling of items for pricing
locally, by first selecting the urban area, then the outlet, and finally the specific item
within the outlet. This method helps to ensure that the sample of items is timely and
representative. The BLS is currently investigating potential uses of point-of-sale
(scanner) data which are available from private vendors, and in the future it might be
possible in some cases for the BLS to use such data to draw national samples of items.17

In summary, the BLS has no specific plans to implement changes to sampling procedures
in connection with this recommendation. It is the current BLS practice to decide,
commodity by commodity, what is the most efficient way to select samples. Samples are
selected at the national level for some commodities, and BLS research will continue on the
geographic structure underlying the CPI.

Recommendation viii.

The BLS should investigate the impact of classification, that is item group
definition and structure, on the price indexes to improve the ability of the index to
fully capture item substitution.

The BLS introduced a new item structure for the CPI with the release of data for
January 1998.18 The ability of the index to
capture consumer substitution was one of the prominent factors that was considered in
developing the new item classification. In putting together the item classification, the
BLS "also tried to see that [the strata] formed natural groups, as consumers would
view them. For example, using the consumer view, items within the same stratum should have
some affinity, such as substitutes (butter and margarine), or complements (washers and
dryers)."19

The commission points to some examples of potential consumer substitutions which cross
item boundaries, such as "on-line news services which compete with newspapers,
automobile purchases with leases, and drugs with surgical procedures they replace,"
arguing that in these cases direct price comparisons are needed so that the full
substitution effect can be measured.20 The
BLS is sympathetic to the commissions concern, and will continue to work to improve
the CPI item structure.21 It seems to us,
however, that no feasible item classification system would completely capture the current
and possible future developments in consumer substitution behavior. Moreover, one must
acknowledge that because any item classification structure relies on a combination of
expert judgment and quantitative evidence, all such structures are by nature somewhat
arbitrary and therefore arguable. Perhaps most important, it does not seem to us that the
item classification system is necessarily the most significant impediment to measuring the
effects of these substitutions. The more fundamental issue is the need to develop
systematic methods for identifying the substitution and accounting for differences in
quality between the substituted items.

In summary, the BLS instituted a new item structure for the CPI in January 1998 that
was designed with an emphasis on its ability to capture consumer substitution. BLS will
continue to work to improve the item structure within the normal framework of index
revisions. Meanwhile, it will continue its research on substitution across item
categories, focusing on the development of superlative measures of the cost of living.

Recommendation ix.

There are a number of additional conceptual issues that require attention. The
price of durables, such as cars, should be converted to a price of annual services, along
the same lines as the current treatment of the price of owner-occupied housing. Also, the
treatment of "insurance" should move to an ex-ante consumer price measure rather
than the currently used ex-post insurance profits based measure.

When the BLS adopted the rental equivalence approach to pricing housing services in
1983, BLS staff were aware that the same conceptual issues arise in the pricing of other
consumer durables.22In
principle the CPI is intended to measure the cost of consuming goods and services, and
durable goods provide a flow of services over time rather than immediate consumption. To
implement a flow-of-services approach, however, requires information either on the costs
that would be associated with renting the durable asset or the user cost associated with
holding the durable asset. In the case of housing, the existence of rental markets makes
it relatively easy to implement the former approach, commonly referred to as the rental
equivalence approach, while the long life of housing assets and the likelihood of price
appreciation made the standard asset price approach uniquely problematic. During the
mid-1980s, BLS researchers investigated the potential use of automobile leasing data to
price automotive services, but at that time concluded that the auto leasing markets were
not sufficiently developed to support a leasing equivalence approach to index
construction. Subsequently, automobile leasing has grown to the point that in 1998 an
automobile leasing stratum was added to the CPI market basket. Currently BLS researchers
are reexamining the flow-of-services approach for automobiles, possibly using a leasing
equivalence methodology. For durables other than automobiles, the lack of widespread
rental markets as well as the lack of data needed for direct estimation of user cost
suggest that the flow of services approach may not be practicable.

The commission recommends that the BLS move the CPI for insurance to an "ex ante
consumer price measure" from the currently used "ex post insurance profit based
measure." The current CPI for health insurance does not directly price policies
purchased by consumers.23 Instead, an
indirect approach to measuring the price of a policy is used; the price is seen as
deriving from the services provided by the insurer and the value of benefits paid to
providers of health care. The BLS prices these two parts separately, obtaining from
insurers information on retained earnings to measure changes in the value of the insurance
service component, and using the price indexes in the CPI medical care component to
measure changes in the cost of the health benefits paid to providers. It is possible that
direct pricing of health insurance policies would have the virtue of automatically
reflecting cost-reducing innovations in the treatment of medical problems (such as the
substitution of less-costly outpatient procedures). The countervailing difficulty,
however, is that health insurance policies can increase or decrease in price due to
changes in coverage or in the characteristics of the covered populations, and these
changes may be very difficult to observe or adjust for in the index.

The current CPI approach was adopted in 1964. Prior to that the CPI collected the price
of the most widely-sold community-rated Blue Cross/Blue Shield policy. That approach was
dropped, however, when it became evident that the quality of the policies was changing in
ways for which it was difficult to adjust the policy price. In 1984-85 the Bureau
experimented with the direct pricing of a sample of health insurance policies but the
experiment was terminated because it again proved too difficult to maintain constant
quality and coverage of risk over time. The BLS recognizes the importance of the health
insurance price movements to consumers as well as to policy makers and will continue to
search for ways to overcome the obstacles to accurate adjustment for changes in policy
characteristics.24

In summary, the BLS is sympathetic to the general spirit of this recommendation and is
investigating the flow-of-services approach for automobiles. The flow-of-services approach
does not, however, appear to be practicable for most durables due to the lack of
widespread rental markets and the lack of data that would be needed for direct estimation
of user cost. Automobile and tenants insurance policies currently are priced directly in
the CPI but health insurance is not, due to difficulties in maintaining constant quality
and coverage of risk over time.

Recommendation x.

The BLS needs a permanent mechanism for bringing outside information, expertise,
and research results to it. At the request of the BLS, this group should be organized by
an independent public professional entity and would provide BLS an improved channel to
access professional and business opinion on statistical, economic, and current market
issues.

The BLS already has in place many mechanisms for bringing in outside information,
expertise, and research results. Business and labor research advisory committees meet
regularly with BLS staff and management and have long been a source of outside information
and expertise. A price research division has been a part of the price index programs since
1965, and much of the discussion of CPI bias has been based upon the results of research
conducted by BLS staff. BLS economists and statisticians routinely solicit opinions from
outside researchers by presenting research papers at conferences and submitting them for
publication at peer reviewed journals. Academic researchers are regularly invited to
present their research findings to BLS staff in seminars. The Bureaus American
Statistical Association-National Science Foundation-BLS fellowship program brings in
scholars for extended on-site research projects. The BLS has funded research by academic
economists when research by experts was needed to solve difficult measurement problems.25

The BLS agrees that continued input from outside researchers is useful. For the past
several years researchers at the National Bureau of Economic Research (NBER) Summer
Institute have devoted specific sessions to index number issues and BLS staff have been
regular participants. Earlier this year BLS asked several outside researchers to review
the decision to adopt the geometric mean formula in the CPI. In addition, the BLS has
participated with the Bureau of Economic Analysis (BEA) and the NBER in a project
addressing the measurement of output and prices for medical care. Currently the BLS is
pursuing a project with outside researchers regarding some of the conceptual issues
underlying the construction of the CPI and its use for escalation.

In summary, the BLS has in place many mechanisms for bringing in outside information,
expertise, and research results from business, labor, academic researchers, professional
economic/statistics organizations, and other Federal statistical agencies. The BLS will
continue to actively solicit such help.